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FREE CASH FLOW VALUATION Presenter Venue Date

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FREE CASH FLOW Free Cash Flow to the Firm = Cash flow available toCommon stockholdersDebtholdersPreferred stockholders Free Cash Flow to Equity = Cash flow available toCommon stockholders

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FCFF VS. FCFE APPROACHES TO EQUITY VALUATION Equity Value FCFF Discounted at WACC – Debt Value FCFE Discounted at Required Equity Return

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FCFF VS. FCFE APPROACHES TO EQUITY VALUATION

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SINGLE-STAGE FREE CASH FLOW MODELS

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EXAMPLE: SINGLE-STAGE FCFF MODEL Current FCFF $6,000,000 Target debt to capital 0.25 Market value of debt$30,000,000 Shares outstanding 2,900,000 Required return on equity12.0% Cost of debt7.0% Long-term growth in FCFF5.0% Tax rate30%

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EXAMPLE: SINGLE-STAGE FCFF MODEL

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USING NET INCOME TO DETERMINE FCFF

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OTHER NONCASH ADJUSTMENTS Added back Amortization Added back Restructuring Expense Subtracted out Restructuring Income Subtracted out Capital Gains Added back Capital Losses Added back Employee Option Exercise Added back? Deferred Taxes Subtracted out? Tax Asset

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USING EBIT AND EBITDA TO DETERMINE FCFF

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USING CASH FLOW FROM OPERATIONS TO DETERMINE FCFF

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CALCULATING FCFE FROM FCFF, NET INCOME, & CFO

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FCFE & FCFF ON A USES OF FCF BASIS

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EXAMPLE: CALCULATING FCFF EBITDA$1,000 Depreciation expense$400 Interest expense$150 Tax rate30% Purchases of fixed assets$500 Change in working capital$50 Net borrowing$80 Common dividends$200

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EXAMPLE: CALCULATING FCFF FROM NET INCOME

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EXAMPLE: CALCULATING FCFF FROM EBIT AND EBITDA

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EXAMPLE: CALCULATING FCFF FROM CFO

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EXAMPLE: CALCULATING FCFE FROM FCFF, NET INCOME, & CFO

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EXAMPLE: CALCULATING FCFE & FCFF ON A USES BASIS

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FORECASTING FCFF & FCFE

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EXAMPLE: FORECASTING FCFF & FCFE Sales$4,000 Sales growth$200 EBIT$600 Tax rate30% Purchases of fixed assets$800 Depreciation expense$700 Change in working capital$50 Net income margin10% Debt ratio40%

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EXAMPLE: FORECASTING FCFF & FCFE

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EXAMPLE: FORECASTING FCFF

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EXAMPLE: FORECASTING FCFE

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ISSUES IN FCF ANALYSIS Financial Statement Discrepancies Dividends vs. FCFEEffect of Shareholder Cash Flows & Leverage FCFF & FCFE vs. EBITDA & Net IncomeCountry Adjustments Sensitivity Analysis Nonoperating Assets

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SIMPLE TWO-STAGE FCF MODELS

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EXAMPLE: SIMPLE TWO-STAGE FCFE MODEL Current sales per share$10 Sales growth for first three years20% Sales growth for year 4 and thereafter5% Net income margin10% FCInv/sales growth40% WCInv/sales growth25% Debt financing of FCInv and WCInv growth30% Required return on equity12.00%

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EXAMPLE: SIMPLE TWO-STAGE FCFE MODEL

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Year Sales growth in % 20% 5% Sales per share$12.000$14.400$17.280$18.144$ EPS $1.200 $1.440 $1.728 $1.814 $1.905 FCInv per share $0.800 $0.960 $1.152 $0.346 $0.363 WCInv per share $0.500 $0.600 $0.720 $0.216 $0.227 Debt financing per share $0.390 $0.468 $0.562 $0.168 $0.177 FCFE per share $0.290 $0.348 $0.418 $1.421 $1.492 Growth in FCFE 20.0% 240.3% 5.0%

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EXAMPLE: SIMPLE TWO-STAGE FCFE MODEL

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DECLINING GROWTH TWO-STAGE FCFE MODEL Competition Later Increases Earnings growth slows Capital expenditures decline FCFE increases Initially High earnings growth Large capital expenditures Low or negative FCFE

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EXAMPLE: DECLINING GROWTH TWO-STAGE FCFE MODEL Current EPS$1.00 WCInv/FCInv40% Debt financing of FCInv and WCInv growth30% Required return on equity12% EPS and FCInv growth for year 5 and thereafter5%

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EXAMPLE: DECLINING GROWTH TWO-STAGE FCFE MODEL Year EPS growth30%21%13%8%5% FCInv per share $1.50 $1.25 $1.00 $0.75 $0.50

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EXAMPLE: DECLINING GROWTH TWO-STAGE FCFE MODEL

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Year EPS $1.300$1.573$1.777$1.920$2.016 FCInv per share $1.500$1.250$1.000$0.750$0.500 WCInv per share $0.600$0.500$0.400$0.300$0.200 Debt financing per share $0.630$0.525$0.420$0.315$0.210 FCFE per share–$0.170$0.348$0.797$1.185$1.526

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EXAMPLE: DECLINING GROWTH TWO-STAGE FCFE MODEL

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EXAMPLE: THREE-STAGE FCF MODELS Current FCFF in millions$ Shares outstanding in millions Long-term debt value in millions$ FCFF growth for years 1 to 330% FCFF growth for year 424% FCFF growth for year 512% FCFF growth for year 6 and thereafter5% WACC10%

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EXAMPLE: THREE-STAGE FCF MODELS Year FCFF growth rate 30% 24% 12% 5% FCFF$130.0$169.0$219.7$272.4$305.1$320.4 PV of FCFF$118.2$139.7$165.1$186.1$189.5

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EXAMPLE: THREE-STAGE FCF MODELS

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SUMMARY FCFF = Cash flow available to all firm capital providers FCFE = Cash flow available to common equityholders FCFF is preferred when FCFE is negative or when capital structure is unstable FCFF vs. FCFE Discount FCFF with WACC Discount FCFE with required return on equity Equity value = PV(FCFF) – Debt value or PV(FCFE) Equity Valuation with FCFF & FCFE

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SUMMARY Depreciation, amortization, restructuring charges, capital gains/losses, employee stock options, deferred taxes/tax assets Adjustments for Calculating Free Cash Flows Sources – adjust for noncash events and work from … Net income EBIT EBITDA CFO Uses Δ in Cash balances and net payments to debtholders and stockholders Approaches for Calculating FCFF & FCFE

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SUMMARY Financial statement discrepancies Dividends vs. free cash flows Shareholder cash flows and leverage FCFF & FCFE vs. EBITDA & Net income Country adjustments Sensitivity analysis Nonoperating assets Issues in FCF Analysis

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SUMMARY Forecast sales growth Assume EBIT margin, FCInv, and WCInv are proportional to sales For FCFE, assume debt ratio is constant Forecasting FCFF & FCFE Two-stage with distinct growth in each stage Two-stage with declining growth from stage 1 to 2 Three-stage model FCF Valuation Models

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